Working Capital Management

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What is 'Working Capital Management'

Working capital management refers to a company's managerial accounting strategy designed to monitor and utilize the two components of working capital, current assets and current liabilities, to ensure the most financially efficient operation of the company. The primary purpose of working capital management is to make sure the company always maintains sufficient cash flow to meet its short-term operating costs and short-term debt obligations.

BREAKING DOWN 'Working Capital Management'

Working capital management commonly involves monitoring cash flow, assets and liabilities through ratio analysis of key elements of operating expenses, including the working capital ratio, collection ratio and the inventory turnover ratio. Efficient working capital management helps with a company's smooth financial operation, and can also help to improve the company's earnings and profitability. Management of working capital includes inventory management and management of accounts receivables and accounts payables.

Elements of Working Capital Management

The working capital ratio, calculated as current assets divided by current liabilities, is considered a key indicator of a company's fundamental financial health since it indicates the company's ability to successfully meet all of its short-term financial obligations. Although numbers vary by industry, a working capital ratio below 1.0 is generally indicative of a company having trouble meeting short-term obligations, usually due to insufficient cash flow. Working capital ratios of 1.2 to 2.0 are considered desirable, but a ratio higher than 2.0 may indicate a company is not making the most effective use of its assets to increase revenues.

The collection ratio, also known as the average collection period ratio, is a principal measure of how efficiently a company manages its accounts receivables. The collection ratio is calculated as the number of days in an accounting period, such as one month, multiplied by the average amount of outstanding accounts receivables, with that total then divided by the total amount of net credit sales during the accounting period. The collection ratio calculation provides the average number of days it takes a company to receive payment, in other words, to convert sales into cash. The lower a company's collection ratio, the more efficient its cash flow.

The final element of working capital management is inventory management. To operate with maximum efficiency and maintain a comfortably high level of working capital, a company has to carefully balance sufficient inventory on hand to meet customers' needs while avoiding unnecessary inventory that ties up working capital for a long period of time before it is converted into cash. Companies typically measure how efficiently that balance is maintained by monitoring the inventory turnover ratio. The inventory turnover ratio, calculated as revenues divided by inventory cost, reveals how rapidly a company's inventory is being sold and replenished. A relatively low ratio compared to industry peers indicates inventory levels are excessively high, while a relatively high ratio indicates the efficiency of inventory ordering can be improved.

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